20 February 2012

With the United States and the European Union (EU) imposing one of the toughest sanction regimes ever on Iran, the world is inching closer to a potential catastrophic war at the heart of the Middle East

Meanwhile, Israel is suggesting a pre-emptive strike if sanctions fail to deter Iran’s nuclear program, and Tehran has vowed to retaliate on an international scale if it comes under attack.

However, determined to lift the economic siege and avoid a potential conflict, Iran has shown an increasing interest in reviving talks. Not only has Iran welcomed successive rounds of IAEA visit to its nuclear facilities, but it has also shown interest in engaging in substantive talks, with Turkey and Russia acting as primary interlocutors.

It is high time for the West to rethink the sanctions track and craft a real strategy by finally giving true diplomacy a chance. This might be our last opportunity to avoid tragedy.

Punishing the Iranian Middle Class

The economic sanctions are targeting Iran’s main exports, namely oil and gas, and increasingly freezing Iran’s central bank out of the global financial system. This has made it extremely difficult for Tehran to engage in large-scale, dollar-denominated international transactions, forcing the country to rely on cumbersome and often unreliable third-party financial institutions to undertake substantial trade deals.

The sanctions have had a cascading effect on Iran’s international trade, with transaction costs rising exponentially and the flow of imports coming under tremendous strain. Around a quarter of Iran’s economy is reliant on oil exports, and the national budget is heavily tied to oil revenues. The domestic economy is already feeling the pinch as the cost of imported products skyrocket.

Under growing U.S. pressure, Iran’s most important regional trade partner, the United Arab Emirates (UAE), has also partially severed financial ties with Tehran, complicating Iran’s ability to import essential primary products, especially food. Making things worse, the EU has imposed sanctions on Iran’s most important port operator, Tidewater Middle East Company, which is responsible for much of Iran’s external trade. These moves are clearly designed to strangle the Iranian economy, going well beyond the nuclear issue.

In addition, Iran is in the midst of an unprecedented rollback in state subsidies, which has placed significant inflationary pressure on the prices of basic commodities. Inflation has already reached double digits, while the multi-billion-dollar manufacturing sector is struggling to access intermediate and high-tech imports from abroad, especially the West. As a result, both the industrial sector and the Iranian main street are bearing the brunt of a tightening economic siege.

The sanctions regime is hurting the Iranian middle class — a historical force for moderation and democratic politics — and increasingly embittering its view of the West. As external pressure intensify, more segments of the society are rallying around the regime.

For many Iranians, the Obama administration has clearly backtracked from its initial promise of rapprochement. The sanctions are a direct betrayal of President Obama’s promise for a mutually respectful, stable, and cordial relationship with the people of Iran. After three years of empty words and disingenuous Persian New Year greetings, the Iranian populace has little goodwill left for the U.S. government.

The Economic Siege

The most vulnerable sector is the currency market, where subjective sentiments are crucial to determining exchange rates. Amid a speculative frenzy, the fear of tightening financial sanctions and currency shortfall has placed downward pressure on the Iranian rial. Within a month, Iran’s currency lost more than 40 percent of its value, forcing the Iranian Central Bank to tighten its monetary policy, impose capital control measures, and inject petrodollar reserves into the domestic economy to stave off growing volatilities in the currency market. In fact, the government has engaged in an unprecedented crackdown on the foreign currency black market and has imposed strict measures to regulate the flow of dollar.

Iran has around $104 billion in foreign currency and gold reserves, giving the country some cushion against currency shocks. However, the sanctions are also targeting Iran’s huge pool of foreign currency reserves, which have been spread across major Western financial institutions, especially in Europe. Therefore, Iran has been forced to transfer most of its gold and foreign currency reserves to Asian and Latin American banks.

To sustain its foreign currency accumulation and trade, Iran will need to rely on its major Asian oil partners. However, the sanctions have been coupled with an intense diplomatic effort to convince Iran’s major Asian trade partners – including South Korea, Japan, China, Turkey, and India – to sever their oil imports.

The Western strategy is twofold. The West has rallied the support of major Arab oil-producing countries, such as Saudi Arabia and the UAE, to supplant any actual and prospective shortfall in oil supply if and when Iran’s exports are squeezed out of international markets. Also, by pressuring Iran’s Asian oil partners, the West is trying to limit Iran’s pool of customers, therefore giving immense leverage to Tehran’s narrowing circle of buyers. South Korea and Japan — key American allies — have tentatively agreed to cut their Iranian oil imports, while India and China are exploiting the situation by forcing Iran to make discounts and practically forcing Iran to buy Indian and Chinese products in return for oil.

Iran’s relatively large and sophisticated economy will need significant dollar reserves to sustain its access to the world’s high-end commodity markets. But it is not clear how Iran will maintain its financial buoyancy if its currency reserves are not continuously refurbished by dollar-denominated oil trade.

So, very understandably, Iran has characterized the sanctions as a “declaration of economic war.” It has threatened to close the Strait of Hormuz if such measures continue to choke off its increasingly fragile (but still buoyant) economy.

Iran’s Economic Resilience

Iran’s strength is its trade surplus, low gross public debt, and relatively large economy (the 17th largest in the world), which has benefited from structurally high oil prices in recent years. Having a low public debt and healthy trade balancemeans that Iran, at least in the short term, can continue to issue bonds and rely on external financing to meet its needs.

Moreover, growing geopolitical uncertainty and rising demand for oil has placed an upward pressure on oil prices. So Iran can still maintain its economic momentum as long as it sustains a relatively stable level of oil trade with alternative customers after the EU embargo comes into effect in June 2012. Despite the sanctions, Iran is still expected to export more than 70 percent of itsoil, so the regime will still be flush with cash in the coming months.

In fact, Iran has already threatened to preempt the EU embargo by cutting off its oil supply to Europe. Iran’s top European oil customers — including Italy, Greece, and Spain — are the continent’s most fragile economies, so any pre-emptive Iranian measure would be a huge blow to the EU economy. A supply shock could further erode market confidence in troubled Eurozone members, driving down credit ratings and raising borrowing costs.

Ultimately, the sanctions will not be enough to cripple the regime. The sanctions could at best target around 10 percent of Iran’s economy, but the regime will have all necessary funds to pursue its nuclear ambitions. In fact, the government has proposed a $443 billion budget for 2012, and it plans to more than double its military expenditures in coming months.

The sanctions are impoverishing and radicalizing the greater (and more moderate) part of the Iranian population, while weakening the hands of the pragmatists who are pushing for diplomacy with the West. But they can neither cripple Iran’s economy in the short term nor halt the country’s nuclear program in the long term.

Destructive Momentum

Iran isn’t only under economic siege. There is already a shadow war underway against Iran as well, as Western and Israeli agencies continue to target Iran’s scientists, nuclear facilities, and military establishments. There is also compelling evidence that foreign agencies such as Israel’s Mossad are supporting domestic separatist movements within Iran. Tensions are flaring, and key actors — namely Iran, the United States, and Israel — may inadvertently talk themselves into war unless nuclear talks are revived.

Additionally, both Iran and the United States are facing crucial domestic electoral tests, resulting in President Obama and Iranian politicians alike displaying an increasingly tough posture on the Iranian nuclear program. Pragmatism and diplomacy could be jeopardized, unless the negotiation track is revived, which would require political will on both sides.

Historically, the Europeans acted as a crucial interlocutor between Iran and the United States. However, the political landscape in major European capitals is rapidly changing. Riding on a post-Libya triumphalist tide, major European leaders, from French President Nicolas Sarkozy to German Chancellor Angela Merkel, are adopting a bellicose stance on Iran.

Repairing the breach of trust between the International Atomic Energy Agency (IAEA) and Iran will be key to resolving outstanding issues over Iran’s nuclear program. However, the departure of former IAEA director Mohamed El-Baradei has been followed by growing tensions between Iran and the technical body. After the release of the controversial IAEA report in November 2011, which heavily relied on rehashed Western Intelligence reports, Iran has raised serious doubts about the neutrality of the new IAEA head Yukiya Amano. In fact, Iran may need confidence-building measures with the very body that is supposed to build trust and communication between Tehran and the West.

Reviving Talks

With ties so frayed between Iran and the West, the onus of reviving talks has fallen on the shoulders of countries such as Turkey and Russia, which have maintained strong ties with their Persian neighbor.

Russia and Turkey have a direct interest in Iran’s stability, since any conflict between the West and Iran could compromise regional security and adversely impact their significant commercial ties with Tehran. Although Russia detests any Western military adventurism close to its borders, Turkey’s booming economy is highly reliant on Iranian energy exports. Any conflict in Iran could also undermine Turkey’s national security and extinguish its hopes for EU membership.

So the stakes are high enough for both Russia and Turkey to channel growing tensions in the direction of talks. Since the 2011 attack on the British Embassyfurther hampers Iran’s communication channels with the West, Moscow and Ankara are the last meaningful bridge between Iran and the West.

Iran seems to be interested in going back to the negotiation table, with top Iranian officials constantly visiting Moscow and Ankara to lay the groundwork for talks. The Iranian economy is feeling the pinch, and Tehran’s military options are limited. If Iran closes the Strait of Hormuz, it will not only invite a military retaliation by an armada of Western navies, but it will also jeopardize Tehran’s ties with neighboring Arab countries as well as China, which considers the stable flow of oil in the Persian Gulf crucial to its energy security.

The pragmatists are proactively pushing for a diplomatic resolution. Both Iran’s President Mahmoud Ahmadinejad and Foreign Minister Ali Akbar Salehi have recently reiterated their country’s interest in reviving talks with the so-called (P5+1), composed of Germany and the five permanent members of the United Nations Security Council. To prove its sincerity, the Iranian leadership last month welcomed a technical visit by IAEA representatives. Both sides have characterized the visit as very constructive, with a mutual agreement to have a subsequent IAEA visit as soon as possible. Iran has already finalized the contents of its response to the EU’s request for nuclear talks, and there is a possibility that Iran’s nuclear chief Fereydoon Abbasi-Davani will join Iran’s chief negotiator Saeed Jalili during the upcoming talks. So far, Istanbul is the prospective site for the negotiations.

Iran may also allow the IAEA to access the crucial nuclear facility in Qom, the Fordow Fuel Enrichment Plant. Iran has rejected any demand for suspending nuclear enrichment, but there is a high probability that the country will agree to concrete confidence-building measures within the framework of Russia’s “step-by-step” approach, whereby Iran’s transparency at every stage of negotiations triggers a corresponding rollback in sanctions.

Toward Tactical and Strategic Recalibration

Sanctions, especially in the case of Iran, do nothing but punish the innocent majority, embitter and radicalize the greater society, and embolden the hardliners at the expense of the pragmatists.

Iran’s economy is just too big to cripple without risking a global energy shock, and the Iranian nuclear complex is just too advanced to dismantle. Iran’s recent announcements of major nuclear achievement, especially the installation of indigenous fuel rods, are a clear indication of Iran’s mastery of the nuclear cycle. Iran will be able to withstand heavy sanctions because the regime will still have billions of dollars to prop up its military and advance its nuclear program.

Therefore, it is crucial for the West to give diplomacy a chance and recalibrate its futile emphasis on sanctions.

Negotiations are not supposed to resolve outstanding ideological and strategic differences, but they are a crucial and necessary step in building confidence and overcoming a deep sense of distrust. War is an unthinkable alternative.

If the West had welcomed the 2010 Tehran Declaration, we would have been in the second year of confidence-building, dialogue, and substantive negotiations by now. Yet there is still hope. Iran’s pragmatists are sensing the urgency of the issue, while interlocutors such as Turkey — undeterred by the West’s snubbing of theTurkish- and Brazilian-brokered breakthrough over Iran’s nuclear program – are tirelessly seeking to avoid a disaster.

The status quo is simply unsustainable, and if President Obama wants to go down as one of history’s best foreign policy presidents, then he has to transcend domestic political pressure and instead focus on the bigger picture. Iran has shown its interest in reviving talks, and Turkey and Russia have supported such a move. The ball is in Obama’s court now.